Acroeconomics and

2. Institutions and economic development
The idea that institutions protecting property rights are key to economic development is not new. 
North (1981) has built his analysis of economic history on this premise. More recently, Hall and 

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2
Jones (1999) have shown the relevance of this idea in explaining contemporary differences in the 
level of economic development across countries.
At the core of the influential paper by Hall and Jones (1999) lies a startling correlation, depicted in 
Figure 1: countries with a better institutional environment have a much higher level of labor 
productivity. The vertical axis of Figure 1 measures output per worker (LOGYL) in 1988 – a similar 
correlation exists with regard to total factor productivity. The horizontal axis measures the quality 
of the institutional environment (GADP), at about the same point in time. The variable GADP 
summarizes perceptions of structural policies and institutional environments encouraging the 
production of output rather than its diversion (through theft, corruption, litigation or expropriation).
1
lo
g
Y
L
GADP
.225
1
6.91856
10.4756
Figure 1 Labor productivity (LOGYL) and institutional quality (GADP) 
Source: Hall and Jones (1999) 
Of course, reverse causation is a serious issue in interpreting Figure 1. Do better institutions and 
structural policies lead to more productivity, or does economic development lead to better policies 
and institutions? Hall and Jones (1999) argue that there is enough exogenous variation in structural 
policies and institutions to identify a causal link from institutional quality to productivity. They 
show that institutional quality is explained by historical and geographic features of countries (such 
1
This variable has been compiled by Knack and Keefer (1995) using ICRG data. It is measured over the period 1986-95 
and consists of a simple average of five indicators; two of which relate to the role of the government in protecting 
property rights against private diversion (law and order, and bureaucratic quality); the other three to the role of the 
government itself as a source of diversion (corruption, risk of expropriation and government repudiation of contracts). 
The variable GADP varies from 0 to 1, with higher values indicating better policies (more protection of property rights).
We return to this variable in sections 4 and 5 below.

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3
as distance from the equator and percentage of the population speaking English or another European 
language). Moreover, these historical and geographic variables are valid instruments for 
institutional quality, in the sense that they influence economic development exclusively through 
their impact on institutions.
Although the instruments used by Hall and Jones (1999) are somewhat dubious, subsequent 
research has confirmed the validity and robustness of their basic insight. In particular, Acemoglou, 
Johnson and Robinson (2001) have shown that the quality of institutions and structural policies as 
measured by GADP is explained by the colonial history of countries. European colonizers pursued 
different objectives. Some colonies were exploited to extract resources; others were settled by 
European inhabitants who transplanted their economic and political institutions. This choice was 
strongly influenced by local conditions at the time of colonization, such as the hospitality of the 
local environment for European settlers and the density of the indigenous population. Acemglou, 
Johnson and Robinson (2001) argue that this pattern of colonization had long lasting and relevant 
implications. The colonies that were exploited for extractive purposes never developed adequate 
institutional infrastructures, while those that were settled by European colonizers developed much 
better institutions that persisted after independence. To test this idea, Acemglou, Johnson and 
Robinson (2001) collected data on the mortality rate of European settlers in the colonies between 
the 17
th
and 19
th
centuries and on the density of the indigenous population at that time. The data are 
strongly supportive: as shown in Figure 2, the index of institutional quality and structural policies, 
GADP, is negatively correlated with settler’s mortality measured in logs, lmort: where settler’s 
mortality was higher, current institutions are worse. Similar results are obtained with the density of 
the indigenous population at the start of colonization. Moreover, these variables are valid 
instruments for institutional quality in the regressions where labor productivity is the dependent 
variable. Finally, the original instruments used by Hall and Jones (1999) loose explanatory power 
once local conditions at the time of colonization are controlled for, suggesting that their 
instruments, and in particular distance from the equator, really proxy for colonial history. More 
recent research by Easterly and Levine (2002) and by Rodrik, Subramanian and Trebbi (2002) 
further confirms the robustness of this link from colonial history to institutional infrastructures to 
current economic development. See also the discussion in Acemoglou, Johnson ad Robinson 
(2004).

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4
GA
D
P
lmort
2.14593
7.98617
.225
.986